Many people think that the value of something is the price that others are willing to pay for it. And to some extent, that is true. However, when investing in stocks, this kind of thinking is very dangerous, and can be extremely damaging to your bank account. It is the investor who knows the difference between price and value who will prosper.
So, what is the difference between price and value?
The price of a stock is quite simple - it is simply the amount at which the stock was last transacted on the stock exchange. You can find it by looking up the financial pages or on a website like finance.yahoo.com
The value of a stock, however, is a different matter altogether. To understand what the value of a stock is, one has to first understand what stock is.
Stocks in a company, or shares in a company, are a piece of property that gives the holder ownership rights to a portion of a company. An owner of stock in a company has a proportionate claim to any future dividends that are paid out by the company as well as any voting rights which give the shareholder to have a proportionate say in matters during shareholder meetings. In the case of a winding up of the company, the shareholder also has a proportionate claim to any residual assets that remain after all other creditors have been paid.
The value, or “intrinsic value”, of a stock is thus the present value of the future cashflows that can be derived from the stock (known as net present value calculated by discounted cash flow analysis) or the net liquidation value that is due to the stockholder in the case of a winding up.
It should thus be obvious that the intrinsic value of a stock can often be a subjective thing - different people will have different estimates of intrinsic value depending on how they foresee the company performing in the future - a person who predicts a strong growing company will have a higher estimate of intrinsic value than a person who believes the company is going to perform poorly.
But one thing is for certain - price is NOT value. Price is simply the amount that two people came to an agreement over which to allow the stock to change hands. Nothing more.
Price can differ from intrinsic value, and often does - and the astute investor tries to buy a stock when its price is trading significantly below its intrinsic value, and sells the stock when the price goes above intrinsic value.
And it is because he understand that price and value are not the same thing, that he is able to profit from this method.